4.4 – Monetary Policy

The money supply is the total value of money available in an economy at a point of time.  The government can control money supply through a variety of tools including open market operations (buying and selling of government bonds) and changing reserve requirements of banks. (The syllabus doesn’t require you to study these in depth)

The interest rate is the cost of borrowing money. When a person borrows money from a bank, he/she has to pay an interest (monthly or annually) calculated on the amount he/she borrowed. Interest is also be earned on the money deposited by individuals in a bank.
(The interest on borrowing is higher than the interest on deposits, helping the banks make a profit).
Higher interest rates will discourage borrowing and therefore, investments; it will also encourage people to save rather than consume (fall in consumption also discourage firms from investing and producing more).
Lower interest rates will encourage borrowing and investments, and encourage people to consume rather than save (rise in consumption also encourage firms to invest and produce more).

The monetary authority of the country cannot directly change the general interest rate in the economy. Instead, it changes the interest rates of borrowing between the central bank and commercial banks, as well as the interest on its bonds and securities. These will then influence the interest rate provided by commercial banks on loans and deposits to individuals and businesses.

Monetary Policy

Monetary policy is a government policy controls money supply (availability and cost of money) in an economy in order to attain growth and stability. It is usually conducted by the country’s central bank and usually used to maintain price stability, low unemployment and economic growth.

Expansionary monetary policy is where the government increases money supply by cutting interest rates. Low interest rates will mean more people will resort to spending rather than saving, and businesses will invest more as they will have to pay lower interest on their borrowings. Thus, the higher money supply will mean more money being circulated among the government, producers and consumers, increasing economic activity. Economic growth and an improvement in the balance of payments will be experienced and employment will rise.

Contractionary monetary policy is where the government decreases money supply by increasing interest rates. Higher interest rates will mean more people will resort to saving rather than spending, and businesses will be reluctant to invest as they will have to pay high interest on their borrowings. Thus, the lower money supply will mean less money being circulated among the government, producers and consumers, reducing economic activity. This helps slow down economic growth and reduce inflation, but at the cost of possible unemployment resulting from the fall in output.

Notes submitted by Lintha

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